Inflation-linked liabilities

The argument here is the need for a balanced liability portfolio in the face of an uncertain economic future. So even if inflation-linked funding sometimes appears expensive to issuers (because implicit inflation appears... 

Corporates balance sheets are full of real assets, so real liabilities are intuitively appealing, and future corporate revenues may not be purely inflation-linked, but they still tend to be more real than nominal. And... 

Anyone who thought that the advent of a Eurozone inflation-linked bond would cause the French CPI linked bonds to wither on the vine has been proved mistaken. Agence France Tresor (AFT) has continued to reopen the two OATi issues, and demand for these, and the domestic inflation-linked bonds of CADES (a government-owned institution created to repay past social security liabilities), has been sufficiently strong for AFT to issue a new 10-year OAT (2.5% July 2013), in January 2003. 

This may all seem rather convoluted, so a simple example might suffice to make the point clear. Let us assume that the average bond investor expects future long-term inflation to be 2.5%, and that the average investor is inflation risk averse, so be prepared to pay a 0.25% risk premium. On this basis alone, we would expect observed break-even inflation to be 2.75%. Now let us say that the govermnent also has inflationary expectations of 2.5%, but it prefers real liabilities to nominal liabilities, and places a 0.25% yield value on that preference. It will prefer to sell inflation-linked bonds rather than nominal bonds until break-even inflation falls to 2.25%. 

In earlier chapters, we reviewed the basic features of index-linked bonds and their main uses. We also discussed the techniques used to measure the yield on these bonds. The largest investors in indexed bonds are long-dated institutions such as pension fund managers, who use them to match long-dated liabilities that are also index linked for example, a pension contract that has payments linked to the inflation index. It is common though for investors to hold a mixture of indexed and conventional bonds in their overall portfolio. 

There are exceptions and provisos, but they are few. Possibly the only material exception is the need for the individual to pay down a nominal home loan over its life, so not all liabilities are ultimately real in the real world. A key proviso is that however well a linking index is constructed, there will be a basis risk between the inflation measured by the index and the personal inflation experienced by the unique basket of goods and services that each saver hopes to consume one day. 

Investors tend to prefer their domestic habitat. When they have domestic liabilities, their first choice will probably be domestic assets. This is all the more likely in index-linked markets, where the inflation protection offered by an Australian linker is likely to be far more valuable to... 

Index-linked bonds often pay interest semiannually. Certain long-dated investors, such as fund managers whose liabilities include inflation-indexed annuities, may be interested in indexed bonds that pay on a quarterly or even monthly basis. 

Hedging pension liabilities. This is perhaps the most obvious application. Assume a life insurance company or corporate pension fund wishes to hedge its long-dated pension liabilities, which are linked to the rate of inflation. It may invest in sovereign IL bonds such as IL gilts, or in IL corporate bonds that are hedged (for credit risk purposes) with credit... 

The net cash flow leaves the pension fund receiving a stream of cash flow that are linked to inflation. The fund is therefore hedged against its liabilities. In addition, because the swap structure can be tailor-made to the pension fund s requirements, the dates of cash flows can be set up exactly as needed. This is an added advantage over investing in the IL bonds directly. 

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